Long Straddle Direction: Volatility in Either Direction

Strategy Description

Long Straddle is one of the delta neutral strategies
employed in a highly volatile stock. It usually involves buying At The
Money puts and calls options with the same strike price, expiration date
and underlying stock.

Limited to the Net Premium Paid for the At The Money puts and calls options.

Maximum Reward :

Potentially unlimited to the upward or downward movement of the underlying stock.

Breakeven :

Upside Breakeven = Strike Price Plus Net Premium Paid

Downside Breakeven = Strike Price Less Net Premium Paid

Net Position:

This is a net debit trade as you are buying the puts and calls options at the same strike price and expiration date.

Advantages and Disadvantages

Advantages:

Potentially unlimited profit potential beyond the breakeven point in either direction.

Make profit from extremely volatile stocks, without having to determine the direction.

Limited risk exposure to the net premium paid when the underlying
stock is at the strike price on expiration date (where both puts and
calls options expired worthless).

Disadvantages:

Time decay hurts long options as options are a wasting asset.
This goes double for this strategy if the strike price, expiration
date or underlying stock are badly chosen.

Significant movement of the stock and options prices is required for this strategy to be profitable.

Exiting the Trade

If the underlying stock surge up, sell the call
options (making a profit for the whole position), and wait for a pull
back to profit from the put options.

If the underlying stock plunge down, sell the put options
(making a profit for the whole position), and wait for a retracement to
profit from the call options.

Offset the position by selling both the puts and calls options that you have bought in the first place.

Long Straddle Example

Assumption: XYZ is trading at $25.55 a share on Mar 20X1.
The verdict of a legal law suit against the company is expected to be
made soon. You are expecting share price of XYZ to soar up or plummet
down once the verdict is out. In this case, you may consider to buy one
Jun 20X1 $25 strike call at $2.50 and buy one Jun 20X1 $25 strike put at
$2.00 to profit from the volatile outlook of the stock. Note: commissions are NOT taken into account in the calculation.

This is one of the most popular volatility strategies and easiest
to understand. You just need to buy an equal number of puts and calls
options of the same strike price and expiration date so that you can
make a profit whether the stock move up or down. The good point is, you
don’t care which direction it move, as long as it moves sharply in
either directions.

For this strategy to be profitable, a rise in the call options
value must be able to exceed the fall in the put options value. Or a
rise in the put options value must be able to exceed the decline in the
call options value. This strategy can be executed at any strike price
but is typically established At The Money.

Try to ensure that the implied volatility of the selected stock
is currently very low, giving you low option prices, but the stock is
about to make an explosively move, just that you are not sure in which
direction.

This is a net debit trade as you are paying the premium for both the puts and calls options.

Remembering that the last month of an option’s life has the greatest amount of time value erosion occurring.

Therefore
it is preferably to use this option trading strategy with at least 3
months left to expiration so as to give yourself more time to be right.

This is typically a bet on the volatility expansion. Verdict of law
suit, product announcement, earning or economic reports do have a
tendency to move the stock price sharply up or down. Some traders prefer
to purchase the straddle at a time of low volatility before the
announcement and sell at a time of high volatility after the
announcement.

You should pick the strike price and time frame of the Long
Straddle according to your risk/reward tolerance and forecast outlook of
the underlying stock. Selecting the option trading strategies with
appropriate risk-reward parameters is important to your long term
success in trading options.